The article “How to use income ETFs for retirement income” was originally published in MoneySense on January 31, 2023 . Photo by Karolina Grabowska from Pexels.
Are income ETFs the right choice for retirees? And should you place them in a life income fund that has minimum withdrawals?
“I am about three years from retirement (hopefully) and am purchasing units of income ETFs in my TFSA and LIRA with an eye toward using the ETF income to supplement my pension income.
I am confused about how the income from the ETFs in the LIRA would be accessed and if the income would count towards the minimum withdrawal amount.
I’m 58, looking to retire at 61.” Garrett
Using income ETFs for a life income fund (LIF)
As you approach retirement, Garrett, it’s good to revisit your investment strategy. It may not necessarily need to change for a conservative investor, but aggressive investors should assess the magnitude and timing of planned withdrawals from their accounts.
If a retiree is only withdrawing a small percentage of an account’s value, the withdrawals may be sustained by income—that is, dividends, interest and similar predictable distributions. Most retirees have to take withdrawals that exceed the income being generated by their accounts, which results in dipping into their investment capital.
Retirees who are not withdrawing all the income generated by their combined accounts may be withdrawing more heavily from one or more accounts while not withdrawing from others. For example, someone with a non-registered account, a tax-free savings account (TFSA) and a registered retirement savings plan (RRSP) may be withdrawing from their non-registered and RRSP accounts, while continuing to contribute to a TFSA.
So, as retirees approach and enter retirement, it can be beneficial to look at how much they may be withdrawing from which accounts and when those withdrawals may be anticipated. This can help assess risk tolerance and time horizon on an account-by-account basis, while considering overall risk tolerance and time horizon across accounts.
Capital return vs dividends
Many investors and commentators embrace dividend investing at different stages of their saving journeys, and especially as they enter retirement. Income exchange-traded funds (ETFs) and mutual funds tend to focus on dividend stocks, real estate investment trust (REITs), corporate bonds, preferred shares and other high-yielding securities.
It is important to point out that just because one stock pays a higher dividend than another, it does not necessarily mean it will generate a higher return. In other words, a stock could pay no dividend and provide a better short-, medium- or long-term return than a high-yielding stock.
Berkshire Hathaway is a great example of a stock that does not pay a dividend. Warren Buffett’s company buys other companies in a variety of industries that are profitable and generate significant cash flow. Rather than paying that cash out as dividends to investors, Berkshire Hathaway uses it to buy other companies to generate a return for shareholders through capital growth. Apple is another example of a company with a low dividend that has generated a high historic return.
Dividend vs growth stocks: Which is better?
The board of directors of a publicly traded company decides whether to pay cash out as a dividend to shareholders or use that money for another purpose, like growing the company’s profits. As profits grow, so, too, does share price.
As a result, a company with a high dividend may not have the same long-term growth prospects as a company that is reinvesting significant cash into growing its business. An established company may be able to pay out a higher dividend because it has lower growth prospects. A company with a lower dividend may provide a higher return through capital appreciation of its stock price. But a company with a 5% dividend will not necessarily earn a 4% higher return than one with a 1% dividend.
How to access income in a locked-in retirement account (LIRA)
My decumulation and dividend diatribe aside, I want to speak directly to your questions, Garrett.
Income ETFs are certainly an option, as you approach retirement. I would not go out of my way to buy them simply because you’re approaching retirement, though. Nor would I build a portfolio consisting only of income ETFs. You may also get enough diversification in a single income ETF that buying many of them is unnecessary.
You can take withdrawals from an RRSP, but its counterpart, a locked-in retirement account (LIRA), needs to be converted to a life income fund (LIF) before you can take withdrawals.
A LIF is a registered account with minimum and maximum withdrawal amounts that change annually, based on the market value of the account on Dec. 31 of the previous year. So, the income generated does not directly impact the minimum withdrawals from an LIF, Garrett. Only the Dec. 31 account value and your age matter. Withdrawals rise at higher ages.
You asked about how to access the income from your income ETF. You should make sure the monthly or quarterly dividends are being paid in cash rather than reinvested into new units of the fund if you need or want it. This will build the cash balance in your LIF and can be used to fund withdrawals. The income alone will probably be insufficient to fund your withdrawals, so you may need to sell units of the ETFs from time to time.
When to consider fixed-income laddering
Some investors build guaranteed investment certificate (GIC) or bond ladders with funds coming due every year to supplement withdrawals as another option, Garrett.
Depending on the timing of when you start your Canada Pension Plan (CPP) and Old Age Security (OAS) pensions, you may want to consider withdrawals that exceed the minimums early in retirement. This may allow you to cover early retirement travel or other expenses, keep a TFSA account intact or maximized, and benefit from low tax brackets in your 50s or 60s. Deferring CPP and OAS can be beneficial for a healthy retiree, especially a DIY investor who may not be as able to do it themselves when they are in their 70s or 80s.
I hope these considerations help, Garrett. Income ETFs could be a good investment and retirement funding strategy for you. However, they may prevent you from having as diversified a portfolio as you could with a broader strategy that’s not so focused on income stocks. If the income eventually falls short of funding your minimum LIF withdrawals, you have the options of selling units or considering a fixed-income ladder.
Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto. He does not sell any financial products whatsoever.